What is Terra (LUNA)?

What is Terra (LUNA)?

Terra is a public blockchain project that enables the execution of smart contracts. As such, Terra can be referred to as a smart-contract platform. Terra’s native platform token is LUNA, which can be staked and used for network governance and plays a vital role in the issuance of stablecoins (TerraSDRs). The project has caught investors’ attention because its market capitalization surged from $315 million on January 1, 2021, to almost $35 billion by the end of Q1 in 2022. This is a return of 71,000% over a 15-month time frame.

Who Is Behind Terra?

The mainnet release of Terra’s public blockchain network happened on April 24, 2019. However, the project was originally founded in January 2018 by two South Korean entrepreneurs.

One of them was Daniel Shin, the founder and CEO of TMON, one of South Korea’s largest e-commerce platforms. This company was a rather big driver behind Terra’s launch. The other South Korean entrepreneur was Do Kwon, who previously headed another startup called Anyfi but took on the position of CEO at Terra Labs, the company behind Terra.

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What Is Terra’s Goal?

Terra’s vision is straightforward: The public blockchain project’s goal is to facilitate the mass adoption of cryptocurrencies by creating digital, blockchain-based assets that aim to be price-stable against the world’s biggest fiat currencies. In other words: The aim is to launch reliable stablecoins.

As such, the visionaries behind Terra have identified that today’s internet lacks native money, particularly price-stable ones. This is why Terra strives to become a hub for programmable internet money. By doing this, the project aims to replace the currently complicated payment value chain, including credit card networks, banks, and other payment gateways. In Terra’s vision, this results in significantly lower transaction fees for merchants, which ultimately benefits e-commerce users. With its end-to-end payment solution, Terra’s transaction costs amount to only 0.5-2% compared to the industry norm of 2.5-3%.

How Does Terra Work?

The Terra protocol is based on Tendermint and Cosmos SDK. These frameworks can be considered open-source, low-level software frameworks to launch blockchains that can be written in any language and are natively interoperable. Because of this, Terra and any DApp on its blockchain are interoperable with any other Cosmos-interoperable projects like BNB chain, THORChain or Crypto.com.

When it comes to its consensus mechanism, Terra is structured as a Delegated Proof-of-Stake (DPoS) algorithm. This means that the Terra blockchain has various validators — currently 130 — and they bond their own Luna to propose Terra blocks. Luna token holders can delegate their Luna tokens to validators by staking their tokens. The validators’ influence (and payout) is determined by the amount of Luna tokens that are delegated to them. The more tokens are delegated to a validator, the greater the validator’s rewards are.

With over $30 billion in Luna tokens staked, Terra is among the three biggest staking blockchains. In total, 41.54% of all Luna tokens are currently staked with the protocol. The biggest staking pool holding Luna is Orion Money, which holds more than 15% of the total Luna tokens supply.

Terra’s DeFi Ecosystem

As of the end of Q1 2022, the Terra ecosystem boasts well over 100 projects that are built on and for the Terra blockchain. These include non-fungible token (NFT) collections, decentralized finance (DeFi) projects, and Web3 applications. Here’s a quick list of the most prominent ones:

TerraSwap: A decentralized exchange (DEX)

What Is UST?

Terra has also reached wider popularity because of its U.S. dollar-denominated stablecoin called TerraUSD or UST. Although the blockchain network has issued many different stablecoins like TerraCNY, TerraJPY, TerraGBP, TerraKRW, TerraEUR, and even the International Monetary Fund’s TerraSDR, UST is their most popular product by orders of magnitude.

Its popularity is mainly due to its phenomenal growth in market capitalization. At the start of 2021, UST’s market cap stood around $180 million. By the end of Q1 2022, it had grown to over $16 billion.

Like other stablecoins, UST aims to have a steady value of $1. What is special about UST is the fact that the stablecoin is not backed by traditional fiat-denominated assets — as in the case of USDC or USDT. As a matter of fact, UST is not backed by any collateral but by an algorithm managing its peg to the U.S. dollar. Essentially, UST represents an algorithmically stabilized coin, as do all other Terra assets for that matter.

How does the algorithm maintain the peg? It relies on market incentives and arbitrage. Market participants are offered the possibility to exchange UST and Luna at any time on-chain at a fixed exchange rate. More precisely, a dollar’s worth of Luna can be burned anytime with one UST being mined in return. Vice versa, one UST can be burned at any time for one dollar of Luna being minted.

As a consequence of this mechanism, the following dynamics ensue: If demand for UST rises its price above $1, a corresponding percentage of Luna tokens is burned and more UST come into existence in return. Similarly, if demand is low for UST and the price falls below $1, arbitrage possibilities emerge that encourage people to burn UST in order to increase UST scarcity, which brings its price back to $1. With UST being burnt, new Luna tokens are created at a one-to-one ratio.

UST — The Bottom Line

Algorithmic stablecoins present an interesting innovation. They are considered the most decentralized stablecoins since they don’t rely on any off-chain assets. So far though, many algorithmic stablecoins like Empty Set Dollar, NuBits, or Basis Cash have not been able to hold their peg and went bust after some time.

Could the same happen to UST? Possibly. In a scenario where UST consistently trades below $1, arbitrageurs buy UST, burn it for Luna tokens and sell them off-chain. This puts downward pressure on Luna’s token price. Should Luna drop unexpectedly fast, investors could lose confidence, so they will burn their UST for Luna (at a fixed ratio of $1) and then sell Luna tokens. With every UST burned, $1 worth of Luna must be mined, which means more Luna tokens are being created as its price falls. This could lead to a vicious cycle ending in hyperinflation.

Luna supporters will argue that, unlike other algorithmic stablecoins, Terra has an entire ecosystem behind it with different use cases for UST like payment solutions and DeFi protocols as well as staking for Luna. Because of its close connection to the Terra ecosystem, Luna will inevitably participate in the success of the ecosystem in the long run.

Also, the Luna Foundation is holding $1.1 billion in Bitcoin as of Q1 2022. This Bitcoin war chest was acquired with the sole purpose of defending the UST rate in critical market times. Bitcoin’s low correlation from the Terra ecosystem — especially compared to Luna or other assets — creates strong protection for UST, so the argument made by supporters goes.

Undeniably, Terra is one of the more successful projects so far. It will be interesting to see whether they will be able to keep on delivering. To date, Terra’s UST is the crypto world’s most successful algorithmic stablecoin. From the perspective of the industry, having an algorithmic stablecoin succeed in the long run, would be a very desirable outcome.